by Jack Crooks
There is no doubt about it; currency analysis is not an easy game. Why do I say that? Because there are different types of players, playing for different reasons, trading different size positions, over varying time frames, and utilizing different forms of analysis.
This I believe is one of the big reasons why if you follow the foreign exchange market sometimes you just scratch your head because price action on a particular day may have had nothing to do with the news or price action in other asset classes.
I think if you have a better understanding of the different players, reasons, and trading styles it will help you understand why, at times, this market can move so differently than other asset classes, such as stocks, bonds, and commodities.
Different Types of Players
and Different Reasons
These can include:
- Corporations hedging exposure on cross-border sales of goods and/or major capital transfers.
- Banks providing these corporations the hedge while reducing their own exposure.
- Equity fund managers hedging the foreign exchange impact on their international portfolios.
- Major funds and propriety trading desks of major financial institutions playing for speculative gain.
- Retail players, like you and me, playing for speculative gain.
Don’t forget central banks that may be doing currency swaps with other central banks or directly intervening in the market for one reason or another.
Each of these players may have different time frames, such as:
And they use different types of analysis, including:
- Fundamental economics
- Technical price action
- Sentiment based on survey and positioning data
One other key point about currencies: Currency trading is real money! Players from all over the world use money (the forex market) to invest in the various global asset classes, as mentioned: Stocks, bonds, and commodities. Therefore, forex plays a dual role as fuel to drive prices in those markets and as a speculative or investment asset class in and of itself.
And it is precisely because forex is the fuel that drives various asset classes that you tend to get very nice inter-market correlations in currencies when compared to stocks or bonds. Therefore, I can’t stress enough how important using simple inter-market correlation analysis can be to either finding trading opportunities or validating or invalidating your current market view.
Correlation Analysis Made Easy
Inter-market correlation analysis tends to work well for currencies because global capital ebbing and flowing across various asset classes and markets is the source of supply and demand for currencies. And inter-market correlations help you follow that money flow and create rationales and scenarios.
There are a couple of basic ways to do inter-market correlation analysis. You can “run the numbers” or you can use the “overlay” technique. Let me briefly explain the two.
By “running the numbers” I mean you compare differing price data with another, usually using a spreadsheet, to calculate the exact correlation over whatever time-frame you use.
With “overlay,” you would put the chart of one price series over top of another. It’s a down and dirty visual analysis that allows you to see if the two price series are moving together in some type of correlation — positively or negatively — or does it just look random.
I like to use the “overlay” technique because it lets me view a lot of different series quite quickly without being bogged down in the minutia.
When using correlation analysis for currencies I compare them to the following asset classes:
- Fixed income indices (government domestic and international)
- Equity indices (domestic and international)
- Commodities (oil, gold, and copper primarily)
Here’s a current example of one I am looking at.
Australian dollar-U.S. dollar versus
Chinese Stock Index Daily
This series, as shown in the chart below, used to be tightly positively correlated i.e. they moved consistently in the same direction. And it made sense in that positive growth and sentiment about China should engender the same feelings about the Australian dollar because the Australian economy is so highly dependent on China for its own growth.
But if stocks are a lead indicator for economic activity, and they may be saying Chinese growth expectations are too high, why did the Australian dollar continue to rally?
The short answer is that we don’t really know.
We can suggest reasons. For instance:
- Maybe the Chinese stock market isn’t a good lead indicator for China’s economic activity as it is government controlled;
- Maybe the Chinese and Aussie past correlation wasn’t accurate, and the movement in the Australian dollar is actually about its high relative yield compared to the U.S. dollar; or
- This is a big divergence in correlation that will soon be remedied by either a big rise in Chinese stocks or a big fall in the Australian dollar or a combination of the two.
The fact is there is no Holy Grail in correlation (inter-market) analysis. Often we don’t know the real drivers of correlations, and we don’t know who leads and who follows. But I think it does help validate the other analysis you are doing. It can provide valuable information; it is another piece of the puzzle, if you will.
Here is how I interpret the divergence in the Aussie and Chinese stocks:
To me it represents a longer term investment opportunity i.e. bearish the Australian dollar, when added to the already bearish view on China for lots of fundamental reasons I shared last week.
I think the path of Chinese stocks is telling us more about China than what I refer to as the “oversized” premium still embedded in the Australian dollar. Much of that premium is based on the high positive yield differential favoring Australia.
But that is changing. And I expect the Reserve Bank of Australia to continue cutting interest rates given their growth concerns, putting a healthy dent in that yield premium going forward.
Here is another example for you to consider:
U.S. Dollar Index versus
Dow Jones Industrial Average (DJIA) Weekly
What I have noticed when comparing these two price series is that the prior tight negative correlation i.e. rising stocks and falling dollar and vice versa, has changed. Now the dollar has generally been moving higher along with the U.S. stock market. No longer are we witnessing a pure “risk on” and “risk off” environment as we did up through 2010.
This tells me money is flowing to the United States for both safe haven and relative investment opportunity. During the prior bull market cycle in the dollar, from early 1990s through 2001, we saw this same correlation — rising stock prices and a rising dollar. Stay tuned on this one!
So that is how I use inter-market correlations. I hope you see how powerful it can be and easy to incorporate into your own style of analysis to help push the odds of success in your favor.
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